© 2008 Pearson Education Canada2.1 Chapter 2 An Overview of the Financial System

© 2008 Pearson Education Canada2.2 An Overview of the Financial System Primary Function of the Financial System is Financial Intermediation The channeling of funds from households, firms and governments who have surplus funds (savers) to those who have a shortage of funds (borrowers).

© 2008 Pearson Education Canada2.3 An Overview of the Financial System

© 2008 Pearson Education Canada2.4 Classifications of Financial Markets Debt Markets Short-term (maturity < 1 year) – the Money Market Long-term (maturity > 10 year) – the Capital Market Medium-term (maturity >1 and < 10 years)

© 2008 Pearson Education Canada2.5 Classifications of Financial Markets Equity Markets - Common stocks Primary Market - New security issues sold to initial buyers Secondary Market - Securities previously issued are bought and sold

© 2008 Pearson Education Canada2.6 Classifications of Financial Markets (Cont’d) Secondary Markets Exchanges Trades conducted in central locations (e.g., Toronto Stock Exchange and New York Stock Exchange) Over-the-Counter Markets Dealers at different locations buy and sell

© 2008 Pearson Education Canada2.7 Financial Market Instruments

© 2008 Pearson Education Canada2.8 Financial Market Instruments (Cont’d) Other Money Market Instruments Certificates of deposit Repurchase agreements Overnight funds

© 2008 Pearson Education Canada2.9 Financial Market Instruments (Cont’d)

© 2008 Pearson Education Canada2.10 Financial Market Instruments (Cont’d) Other Capital Market Instruments Canada savings bonds Provincial and municipal bonds Government agencies securities

© 2008 Pearson Education Canada2.11 Internationalization of Financial Markets International Bond Market Foreign bonds - sold in a foreign country and denominated in that country Eurobonds – denominated in a currency other than the country in which it is sold Eurocurrencies – foreign currencies deposited in banks outside the home country

© 2008 Pearson Education Canada2.12 World Stock Markets

© 2008 Pearson Education Canada2.13 Function of Financial Intermediaries Financial Intermediaries Engage in process of indirect finance Are needed because of transactions costs and asymmetric information

© 2008 Pearson Education Canada2.14 Function of Financial Intermediaries (Cont’d) Transactions Costs 1. Financial intermediaries make profits by reducing transactions costs. 2. They reduce transactions costs by developing expertise and taking advantage of economies of scale.

© 2008 Pearson Education Canada2.15 Function of Financial Intermediaries (Cont’d) Risk Sharing Create and sell assets with low risk characteristics and then use the funds to buy assets with more risk (also called asset transformation) Lower risk by helping people to diversify portfolios

© 2008 Pearson Education Canada2.16 Asymmetric Information Adverse Selection Before transaction occurs Potential borrowers most likely to produce adverse outcomes are ones most likely to seek loans and be selected

© 2008 Pearson Education Canada2.17 Asymmetric Information (Cont’d) Moral Hazard After transaction occurs Hazard that borrower has incentives to engage in undesirable activities making it more likely that loan won’t be paid back

© 2008 Pearson Education Canada2.18 Financial Intermediaries

© 2008 Pearson Education Canada2.19 Size of Financial Intermediaries

© 2008 Pearson Education Canada2.20 Regulation of Financial Markets

© 2008 Pearson Education Canada2.21 Regulation of Financial Markets Primary Reasons for Regulation 1.Increase information to investors - Decreases adverse selection and moral hazard problems - Securities commissions force corporations to disclose information

© 2008 Pearson Education Canada2.22 Regulation of Financial Markets (Cont’d) Primary Reasons for Regulation (continued) 2. Ensuring the soundness of intermediaries -Prevents financial panics -Restrictions on entry/assets/activities, disclosure, deposit insurance, limits on competition